Up and Down Again!
|Do you get a sense of déjà vu? Global equity markets have been all over the place - again. However, there are some differences - this time around the credit markets are continuing to function. During the worst of the global financial crisis, in 2008 and 2009, confidence in the global credit system evaporated – corporate lending spreads (the amount of extra interest a company has to pay above the Reserve Bank rate to compensate for its perceived higher level of risk) blew out to previously unimaginable levels, banks refused to lend to each other, and global trade plummeted as trade finance dried up.|
Equity markets are now responding to what are two concerns. Firstly, fear of a good old-fashioned growth recession in developed economies; and secondly, a question of competency, as markets evaluate the ability of policymakers in Europe and the United States to deal with their respective fiscal challenges.
Global economic growth to slow
|On the growth front, indications are that growth slowed in the US and Western Europe during the June quarter, with both manufacturing and consumer demand slowing. The causes were several, for example a higher oil price affecting consumer spending in the US and austerity measures curtailing consumer spending, whilst the Japanese tsunami caused shortages of certain production inputs that triggered manufacturing delays. Business surveys indicate the global manufacturing downturn intensified during July. |
The problem now is that this growth slowdown may well be exacerbated by the fiscal imbroglio in the US. The US debt ceiling agreement, as it stands, makes for a restrictive fiscal environment in 2012, with the result that market economists are lowering growth forecasts. The US can fix its fiscal problem anytime it wants to by either cutting entitlements or raising taxes, or both. Politically they will wait until forced. Remember Winston Churchill’s wry comment: "You can always rely on the Americans to do the right thing... after they've exhausted all the alternatives."
In Europe, the fiscal restraint required of several of the deeply indebted countries similarly will be a constraint on growth. The implication for northern hemisphere equity markets is that earnings forecasts will have to come down.
Australia should remain resilient
|Australia appears better placed than most developed countries to deal with financial challenges. While a synchronised slowdown in developed economies would no doubt put pressure on commodity prices, demand from China and other EM countries should continue to underpin demand for our commodity exports. Australian unemployment is 4.9% versus the US at 9.1% and our public finances are the envy of most other developed nations. Australia has a very strong domestic banking sector and the economy has much greater leverage to China than it does to the US (25% of Australian exports go to China whilst only 4% go to the US). Furthermore, the Australian government and the Reserve Bank have a well-stocked armoury of policy responses available to spur the economy, in the form of fiscal and monetary stimulus respectively – as was the case during the worst of 2008 and 2009. The Reserve Bank has ample scope to cut interest rates and provide liquidity support for banks if necessary. There is also space to delay the return to surplus given the low level of government net debt.|
Our equity market will no doubt be correlated to international markets, but perhaps to a lesser degree than during the last crisis. With the growth supports described above, the risk to earnings forecasts will not be as great, balance sheets have been strengthened both via capital raisings and lengthening of debt maturities, and our banking system remains one of the strongest in the world.
|No doubt there remains a risk that the global banking system will be tested again. The ultimate resolution of the European sovereign debt predicament may well turn out to be similar to comparable crises during the 20th century – bond holders and lenders will have to take a “haircut” on their loans. In other words, lenders may not get all their capital back or may have to accept a lower rate of return on the money lent. As a result, many of Europe’s banks may well need re-capitalising. However, the precedent of government sponsored bank rescues and market based recapitalisations during 2008 and 2009 gives some confidence that equity markets will not approach the nadir of the earlier crisis.|
Current concerns will no doubt prolong the uncertainty in the share markets. That being said, it is strange indeed that investors believe that the right response to a US credit rating downgrade and to European political ineptitude is to indiscriminately dump global and Australian shares that mostly have never had stronger balance sheets, higher sustainable dividend yields, or a lower true risk of financial failure. According to a new report from Moody’s Investors Service, U.S. companies are sitting on a cash hoard of US$1.24 trillion, which should lead to more capital spending, shareholder distributions, and mergers and acquisitions. Furthermore, 160 of the companies in the S&P500 will pay higher dividend yields than the yield on a US 10 Year Treasury.
The bottom line is: Don't panic. This is not 2008 and many companies are now in much healthier shape than they were when Lehman Brothers collapsed. Yes, there will be unnervingly wild days on the share market. Yes, there are reasons to be cautious as we consider a weaker economic outlook for the rest of the year, but that should not necessarily lead investors to sell in haste. Markets are often volatile and that this is part of the process. Investments should be made for the long term. All the trading over the last month has added significant trading and tax costs for many investors and very little return for most of them. For those that have put long term investment strategies in place, this short term volatility should not detract from that longer term goal. At times like these it is important to remember the benefits of portfolio diversification and of sticking to your investment strategy.